Banking questions and answers

Banks are a critical ingredient to the growth of any economy. Guided by the functions of a bank as an intermediary, discuss how banks can influence the growth of economies.

Banks provide 5 major functions:

1) Create employment

One of the biggest economic benefits emanating from the banking function is that they create employment to a number of a country’s citizens. As they go along serving their clients bank need manpower in the form of human labour and thus in that regard they become critical catalysts for economic growth.

2) Facilitate national payments

Banks in the main make any economy tick. They facilitate national payments under the supervision of the Central Bank. A country’s citizens are able to access their salaries through banks, international trade and other cross border payments are facilitated through commercial banks which make them pivotal in economic development.

3) Attract funds from depositors and on lend to deficit units of the economy there by encouraging economic growth.

Through their branch infrastructure, banks are able to tap resources in the form of savings from surplus units of the economy and they then on lend that mostly to large corporations who in turn use the money to grow commerce and industry thus developing the economy. In the case of governments, the government borrows

mostly to fund infrastructure development which acts as a catalyst for economic development.

4) Cut (Reduce) Transaction costs

As intermediaries one of the functions of a bank is to minimize transaction costs. Through intermediation, banks provide an avenue/platform for parties that are unfamiliar to each other to meet and transact thus in the process reducing cost of doing business with one another. Banks gather information on borrowers in bulk, and by the mere fact that they have that infrastructure that both borrowers and lenders utilizes, this results in the cost of doing business going down for parties

5) Facilitate and participate in the dissemination of monetary policy objectives.

Banks are an agent to The Central Bank of any country. They assist in the dissemination of monetary policy objectives. As an example when there is a fight against inflation spearheaded by the Central Bank, banks are the main tool that the central bank will use in terms of curbing growth in money supply. When The Central Bank changes the repo rate either way, banks are expected to adopt that and allow that to filter to the rest of the economy thus impacting negatively or positively on interest rates depending on the main drive from the Central Bank

6) Maturity transformation and risk transformation.

Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs and in the process they aid in economic development) Banks also play a big role in converting risky investments into relatively risk-free ones. (Lending to multiple

borrowers to spread the risk)

What are the main functions of money? Which ones are the most important and why?

The main functions of money are as listed below:

1) Money is used as a means of storing value.

When Money is used as store of value there are inflationary implications that are attached to this use. Money must retain value in the sense that any holder of assets should be comfortable to convert them into money and should be able to convert the money to the original asset without in the process incurring any loss. A store of value is any form of wealth that maintains its value without depreciating. Commodities such as gold and other forms of metal are good stores of value, as their shelf lives are essentially perpetual, whereas a good such as milk is a terrible store of value due to its natural process of spoilage. This is considered as one of the most important uses of money as it has a bearing on wealth preservation. Attached to this function is the quality of durability and scarcity too. Money should relatively be scarce in order for it to retain value. If all had access to it, it will cause inflation to increase.

2) Money is used as a means of exchange

Money is used to facilitate transactions. As a means of exchange, money enables us to live our lives minus the barter type of trade. With Money every household is able to buy anything of their choice without worrying about looking for something that the other party must be interested in as was the case during barter trades. To this end money is therefore associated with the quality of divisibility

hence we have money in different denominations in order to facilitate both small and larger transactions.

3) Money is used as a unit of account

A unit of account in economics is a nominal monetary unit of measure or currency used to value/cost goods, services, assets, liabilities, income, expenses; i.e., any economic item. It is one of four well-known functions of money. It lends meaning to profits, losses, liability, or assets. Unit of Account – Prices are quoted in terms of money rather than other goods. For example, the price of a litre of milk will be quoted as R13, 00 per litre. To this end, money is associated with the quality of easiness to recognize. Money should be acceptable to all who receive and thus should easily be recognizable and its value must be agreed to by all parties to a transaction.

4) Money is used as a means of deferred payment

A standard of deferred payment is the accepted way, in a given market, to settle a debt – a deferred payment is not as widely used as other terms for functions of money, namely medium of exchange, store of value, and unit of account, though it is distinguished in some works. This function ties in well with the store of value function in that when a service /product provider parts with his/her product /service before payment the service/product provider should not incur a loss at the time of receiving the money.

a) What are the main functions of money? [16]b) Justify your answer in (a) [4]

1. Medium of exchangea. Generally acceptable means of paymentb. It allows us to move beyond barter economyc. It prevents double coincidence of wantsd. Monetary economics are much better

2. Unit of accounta. It enables comparison as a common measure of the costb. Also allows us to work GDPc. Can lose value due to inflation

3. Money as a store of valuea. That is for holding savings, which is convenient and easy

to use at a later dateb. Can also have assets through which you are better off at

times of inflationc. However money is not the only store of value

4. Standard of deferred paymenta. You pay bank a loan in Randb. It is also the means by which credit is granted

Briefly discuss any three (3) qualities of money [6 marks]

1. General AcceptabilityIt is the very essence of money. Unless a person knows that the money which he accepts in exchange for his goods or services will be taken without any objection by others as well, he will not accept it

It will cease to be current. In order to possess general acceptability, a commodity should have some intrinsic utility independent of its value for monetary purpose. Gold and silver are generally acceptable to all without any hesitation because they are used for ornamental and other purposes and can be

easily sold as bullion, besides being used for monetary purposes.

2. PortabilityA commodity fit to be used as money must be such that is can be easily and economically transported from one place to the other. In other words, it must possess high value in small bulk. Precious metals possess this quality. In the case of oxen and grain, a small value occupies a large bulk and weight; hence, they are unsuited as money commodity.

3. DurabilityAs money is passed from hand to hand and is kept in reserve, it must not easily deteriorate, either in itself or as a result of wear and tear. “It must not evaporate like alcohol, nor purely like animal substance, nor decay like wood, nor rust like iron.

Destructible articles, such as eggs, dried cod fish, cattle or oil has certainly been used as currency; but what is treated as money one day must not soon afterwards be eaten up.” Gold coins are very lasting; they take about 8,000 years to wear out completely. Silver coins are not equally lasting but wear out fairly slowly. As such gold and silver are considered to be excellent money commodities.

4. HomogeneityAll portions or specimens of the substance used as money should be homogeneous, that is, of the same quality, so that equal weights have exactly the same value. In order that a commodity may be used as a measure of value, it is essential that its units are similar in all respects. Gold and silver are of the same quality throughout; their various parts are similar in

chemical and physical composition and their consistency is the same throughout the mass

5. DivisibilityThe money material should be capable of division; and the aggregate value of the mass after division should be almost exactly the same as before. If we use diamond as money and by chance it drops from our hand and breaks, we will suffer an enormous loss. This is not the case with precious metals. Their portions can be melted and remelted together any number of times without much loss.

6. MalleabilityThe money material should be capable of being melted, beaten and given convenient shapes. It should be neither too hard nor too soft. If the former, it cannot be easily coined; If the latter, it would not last long. It should also possess the attribute of impressionability so that it may easily receive the impressions.

7. CognizabilityBy it, we mean the capability of a substance for being easily recognised and distinguished from all other substances. As a medium of exchange, money has to be continually handed about; and it will cause great inconvenience if every person receiving it has to scrutinise, weigh and test it.

It should have certain distinct marks which nobody can mistake. Gold and silver are at once recognised by their distinctive colour, metallic and heavy weight for small bulk, and, as such, satisfy this condition admirably.

8. Stability of Value

Money should not be subject to fluctuations in value. Fluctuating standard of value is just like a changing yard or kilogram. The value of a material, which is used to measure the value of all the other materials, must be stable.

The ideal money commodity should, as such, possess utility, portability, durability, homogeneity, divisibility, malleability, Cognoscibility and stability of value.

What role do financial institutions play under intermediation and in your answer highlight the main cost advantages of intermediation [20 marks]

Financial intermediaries provide 6 major functions:

1. Maturity transformation – Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs)

2. Risk transformation – Converting risky investments into relatively risk-free ones. (Lending to multiple borrowers to spread the risk)

3. Convenience denomination – Matching small deposits with large loans and large deposits with small loans.

4. They borrow from one group of agents and lend to another group of agents.

5. The borrowing and lending groups are large, suggesting diversification on each side of the balance sheet.

6. The claims issued to borrowers and to lenders have different state contingent payoffs

There are 2 essential advantages from using financial intermediaries:1. Cost advantage over direct lending/borrowing

2. Market failure protection: the conflicting needs of lenders and borrowers are reconciled, preventing market failure.

The cost advantages of using financial intermediaries include:

1. Reconciling conflicting preference of lenders and borrowers2. Risk aversion: intermediaries help spread out and decrease

the risks3. Economies of scale: using financial intermediaries reduces

the costs of lending and borrowing4. Scope: intermediaries concentrate on the demands of

lenders and borrowers and are able to enhance their products and services (use same inputs to produce different outputs)

Describe the specific roles played by Discount Houses, Merchant Banks and Insurance companies in the intermediation process [15 marks]

- Discount Houseso Prior to and during the early ages of financial

independence the discount houses were used by central banks as the vehicle of communication between the central bank on one hand and the commercial banks and the investing public. In some way central banks would indirectly communicate critical monetary policy issues on interest rates through the discount houses. The central bank would issue instruments like treasury bills and government stocks through the discount houses. This was done for a variety of reasons among which were the following

Mopping up excess liquidity from the market Genuinely raising funds from the investing public on

behalf of the government Giving an indication to the market on the direction

of interest rates. In situations where central banks wanted to ease

liquidity problems in the market they would buy certain type of paper through discount houses

o In adding to the critical role discussed above the discount houses would take short term money from the commercial banks and recycle it into short term investments.

- Merchant Bankso Traditionally merchant banks have been the vehicle

through which international trade is financed. They deal in wholesale depositions and their transactions are very massive in size. These facilitate trade between foreign players through the issuance of letters of credits and other offshore funding arrangements. Most parastals tend to issue bonds and other financial instruments though merchant banks. These instruments are normally used to fund the development of infrastructure and major construction projects. Merchant banks are key players in the secondary/primary markets because of their ability to access international credit.

- Insurance companieso Insurance companies are big mobilisers of funds; they

pick up deposits from ordinary households in the form of insurance premiums and other annuities and repackage it for consumption by large corporations including governments. They play a pivotal role in the development of infrastructure and are also big buyers of primary market paper. We have seen the primary role of

insurance companies change over the past decade because of their crucial ammunition, these institutions are cash rich and we have seen a lot of banks luring them to bed because of their liquidity positions.

What are the instruments at the Central Bank’s disposal as it executes its’ monetary policy function of maintaining price stability? [3 marks]

1. Open Market Operations2. Repo rate policy3. Use of the exchange rate

Briefly discuss any four monetary policy objectives of central banks and comment on the performance of the central bank of your own country on these over the last two years [16 marks]

Monetary policy objective

1. Maintain a stable exchange rate2. Achieve acceptable levels of economic growth

a. One of the most important objective of monetary policy in recent years has been to rapid economic growth of an economy. Economic growth is defined as “the process whereby the real per capita income of a country increases over a long period of time”

3. Equitable distribution of income4. Maintain price stability

a. Price stability reduces uncertainty in the economy and, therefore, provides a favourable environment for growth and employment creation. Furthermore, low inflation contributes to the protection of the purchasing power of all South Africans, particularly the poor who have no

means of defending themselves against continually rising prices.

5. Achieve and maintain a positive balance of payment positiona. Equilibrium in the balance of payments is another

objective of monetary policy which emerged significant in the post war years. This is simply due to the problem of international liquidity on account of the growth of world trade at a faster speed than the world of liquidity. It was felt that increasing of deficit in the balance of payments reduces, the ability of an economy to achieve other objectives. As a result, many less developed countries have to curtail their imports which adversely effects development activities. Therefore, monetary authority make efforts that equilibrium should be maintained in the balance of payments

In South Africa, the MPC meet every Thursday of the last week of the month, and their role is to curb or minimize the inflation rate through manipulation of the repo rate, and during 2015, the repo rate was increased by 0.5 base point leading to increase in interest rate by the commercial banks 2015/2016

Name any five instruments that qualify for liquidity purposes that are at the discretion of the central bank? [10 marks]

The instruments that qualify for liquidity purposes are at the discretion of the central bank and in most situations the following instruments qualify:

1. Notes and coins (both local and foreign)2. Nostro balances3. Treasury bills with a tenure of not more than a year.4. Government stock with tenure of not more than one year5. Other stocks as specified by the central bank

6. Balance in accounts with central bank7. Balance or call money with other banks

What are the effects of an increase in the money supply on interest rates, prices and output? Discuss both the long run and short run effects [10 marks]

Increase in the money supply by the central bank leads to decrease in interest rate, and decrease in interest rate leads to increase in quantity of money demanded, then increase in quantity demanded, which lead to increase in price of the quantity and output!

Decrease in money supply lead to increase in interest rate, increase in interest you can say lead decrease in investment by firms, then price of output will increase due to shortage.

In a short run, increase in money suppy decrease in interest rate then increase in disposable income, demand is higher then price goes up (money supply increase, interest rate decrease, disposable income increase, quantity demanded increase price goes up (short run) then price goes up, the firm increase production due to higher prices, this lead to over production then the prices of output goes down as demand slows down due to high prices)

Give reasons for the existence of financial intermediaries and discuss any 5 services these financial intermediaries offer to the public [20 marks]

Financial intermediation consists of “channelling funds between surplus and deficit agents”. A financial intermediary is a financial institution that connects surplus and deficit agents. One reason that financial intermediaries are important is that the overwhelming proportion of every dollar/rand financed externally comes from banks. Bank loans are the predominant source of external funding in

almost all the countries. As the main source of external funding, banks play important roles in corporate governance, especially during periods of firm distress and bankruptcy. Services of intermediaries, pooling savings, safekeeping and accounting, providing liquidity and diversify risk, and collecting and processing information service

1. Pooling savings a. By accepting resources from a large number of small

savers/ lenders in order to provide large loans to borrowers

2. safekeeping and accounting a. By keeping depositors savings safe, giving them access to

the payments systems and providing them with accounting statements that help to track their income and expenditures

3. Providing liquidity a. By allowing depositors to transform their financial assets

into money quickly easily and at low cost4. diversifying risk

a. Providing investors with the ability to diversify even small investment

5. Collecting and processing information servicesa. By generating large amounts of standardized financial

information- Financial intermediaries channel funds between SSUs and

DFUs. (savers and borrowers)- Risk Transformation role- Payment role- Certification role- Advisory role- Maturity Transformation- Convenient denomination

- Market failure protection- Risk aversion – spreading our risk- Economies of scale- Reconciling conflicting preferences of lender and borrowers

Compare the following financial instruments in terms of their safety and liquidity. Justify your rankings in all instances from the most liquid instrument to the least [20 marks]

a) Negotiable certificates of depositsb) Government Treasury billsc) Commercial paperd) Mortgage Bonds

1. Government treasury billsa. Government treasury bills are liquid, safe and secured as

the government’s risk of default on payments is very low2. Negotiable certificates of deposits

a. Negotiable certificates of deposits are money market instruments which are short term. They are more liquid than a Bond and TBs.

3. Mortgage Bondsa. Mortgage Bond is the most illiquid and long term in

nature although safe and secured4. Commercial paper

a. Commercial paper is traded in the money markets and has a lower risk as it is short term in nature and mature within a year

Negotiable certificates of deposits – a negotiable certificate of deposit, usually abbreviated to NCD, is a fixed deposit receipt issued

by a bank that is negotiable in the secondary market for financial assets. The issuing bank undertakes to pay the amount of the deposit plus the interest on maturity date (in the case of short term NCDs), or interest six-monthly in arrears and the deposit amount on maturity (in the case of long NCDs).( solves short term liquidity needs)

Treasury bills which have a maturity of less than one year when they are issued and traded in the money market. They are considered to by risk-free because they are backed by the government (No risk – much more liquid investments)

Commercial paper – short-term, privately issued zero-coupon debt that is low risk and very liquid and usually has a maturity of less than 270 days (short-term unsecured promissory notes issued by companies, it is considered a very safe investment)

Mortgage bonds – a mortgage bond is bond backed by a mortgage or pool of mortgages. These bonds are typically backed by real estate holdings and/or real property such as equipment. In a default situation, mortgage bondholders have a claim to the underlying property and could sell it off to compensate for the default. (Has very little liquidity risk)

1. Treasury bill 2. NCD 3. commercial paper 4. Mortgage bond last

Identify and discuss any three types of Financial Institutions that operate in your economy and highlight their main contributions to the development of that particular economy [15 marks]

Commercial banks: These institutions, also known as Depository Institutions, were established to provide banking services to

businesses, allowing them to deposit funds safely and borrow them when necessary. Today, many commercial banks offer accounts and loans to individuals as well. Banks obtain their funds from individual depositors and businesses, as well as by borrowing from other financial institutions and through the financial markets. They use these funds to make loans, purchase marketable securities, and hold cash.

The main contributions of commercial banks, to the development of the economy are:

- Capital formation:

- Creation of Credit

- Channelling funds to productive investments

- Encouraging the right type of Industries

Investment Banks

Investment banks are the conduits through which firms raise funds in the capital markets. Through their underwriting services, these investment banks issue new stocks and a variety of other debt instruments. Most commonly, the underwriter guarantees the price of a new issue and then sells it to investors at a higher price, a practice called placing the issue. The underwriter profits from the difference between the prices guaranteed to the firm that issues the security and the price at which the bond or stock is sold to investors. But because the price at which the investment bank sell the bonds or stocks in financial markets can turn out to be lower than the price guaranteed to the issuing company, there is some risk to underwriting. For most large issues, a group of investment banks will band together and spread the risk among themselves rather than one of them taking the risk alone.

Information and reputation are central to the underwriting business. Underwriters collect information to determine the price of the new securities and then put their reputations on the line when they go out to sell the issues. A large, well-established investment bank will not underwrite issues indiscriminately. To do so would reduce the value of the bank’s brand, along with the fees the bank can charge. In addition to underwriting, investment banks provide advice to firms that want to merge with or acquire other firms. Investment bankers do the research to identify potential mergers and acquisitions and estimate the value of the new, combined company. The information they collect and the advice they give must be valuable because they are paid handsomely for them. In facilitating these combinations, investment banks perform a service to the economy. Mergers and acquisitions help to ensure that the people who manage firms do the best job possible. Managers who don’t get the most out of the resources entrusted to them risk having their company purchased by executives who can do a better job. This threat of a takeover—sometimes described as the market for corporate control—provides discipline in the management of individual companies and improves the allocation of resources across the economy.

Pension Funds

A pension fund offers people the ability to make premium payments today in exchange for promised payments under certain future circumstances. Pension funds do not accept deposits, they help people to develop the discipline of saving regularly, getting them started early and helping them to stick with it. The earlier a person begins saving and the more disciplined he or she is, the better off that person will be later in life. Saving from an early age means enjoying a higher income at retirement. Pension plans not only provide an easy way to make sure that a worker saves and has sufficient resources in old age; they help savers to diversify their risk.

By pooling the savings of many small investors, pension funds spread the risk, ensuring that funds will be available to investors in their old age. People can use a variety of methods to save for retirement, including employer sponsored plans and individual savings plans, both of which allow workers to defer income tax on their savings until they retire.

Discuss the main determinants of interest rates and comment on the behaviour of interest rates in your own country over the past three years [15 marks]

If Money supply increases from M0 to M1 interest rates will decrease from i0 to i1 and vice versa.

1. Repo ratea. If the repo rate increases interest rate will also increase

and vice versa. There is a direct relationship between the two.

2. The central bank determines the repo rate thereby influencing the interest rates.

3. Other investment players

4. The market forces of demand for money and supply for money. Equilibrium interest rate in the market is determined where Ms = L as shown above

What are the effects of an increase in the supply of money on interest rates, prices and output? What are the effects of a decrease in the supply of money on interest rates, prices and output? Do these effects occur simultaneously? [20]

If the central bank increase money supply the Ms curve will shift to the right from Ms0 to Ms1 thereby decreasing interest rates from i0 to i1 as shown above formulating a new equilibrium point of E1 where the demand for money curve (L) meets Ms1.

Prices of goods and services will increase as a result of a lot of money circulating in the economy thereby causing inflation. However this can be used by the central bank as a tool to stimulate economic growth although it is inflationary as witnessed in Zimbabwe during the year 2008 being the repercussions associated with printing more money.

if interest rates decrease investments will increase, automous aggregate spending will go up thereby increasing the equilibrium level of income and ultimately shifting the aggregate demand curve to the right thereby increasing the national output.

If the central bank decreases money supply the Ms curve will shift to the left from Ms0 to Ms1 thereby increasing interest rates from i0 to i1 as shown above formulating a new equilibrium point of E1 where the demand for money curve (L) meets Ms1.

Prices of goods and services will decrease as a result of a lot of money circulating in the economy thereby causing deflation. However this can be used by the central bank as a tool to stimulate economic growth by reducing hyperinflation as witnessed in Zimbabwe during the year 2008 being the repercussions associated with printing more money.

If interest rates increase investments will decrease, autonomous aggregate spending will go down thereby decreasing the equilibrium level of income and ultimately shifting the aggregate demand curve to the left thereby decreasing the national output.

Financial instrument, their safety and liquidity [20]

a. Commercial paper – is traded in the money markets and has lower risk as it is short term in nature and mature within a year.

b. Negotiable certificates of deposits are money market instruments which are short term. They are more liquid than a Bond and TBs.

c. Government Treasury Bills are liquid, safe and secured as the government’s risk of default on payments is very low.

d. Mortgage Bond is the most illiquid and long term in nature although safe and secured